The DXY (USD index) once again remained broadly range bound this past month as it moved between strength and weakness and ultimately remained broadly unchanged. Many of the same risks remain, with some trade conflicts in a “ceasefire" mode but materially unresolved. Additionally, political risks have moved to the forefront with senior White House officials resigning, Fed Chair Powell under pressure, the government shutdown continuing and the Mueller investigation looming.
Growth divergence between the US and the rest of the world remains a theme. Much talk has been had over the global slowdown, Fed normalization and fading fiscal stimulus. However, US economic data remains strong, fiscal stimulus, while fading, still remains a tailwind and monetary conditions are still accommodative. This implies a near term bias for a stronger dollar but at a much more muted level relative to earlier in the year.
Over a longer horizon, the softening outlook for global growth has raised the prospect of the Fed slowing its hiking pace in 2019 as evidenced by the Fed taking down its economic forecasts. Moreover, increased optionality provides the Fed with greater opportunity to pause and maintain rate hike flexibility. For the near term, the markets appear to be pricing in a slower normalization cycle with US 10 year yields falling to their lowest level since March 2018. Even if US growth has peaked, we ultimately need to see a broad stabilization in global growth before more meaningful dollar vulnerability.
Significantly, policy and political risks also remain. On one hand trade tensions have benefited the dollar. On the other hand, tribal politics has raised its ugly head with the government shut down over the border wall funding. This supports the possibility of a bumpy 2019 with risks around fiscal accidents (debt ceiling, government shutdowns) and a potential impeachment process contingent on the Mueller investigation findings. All these issues should continue to hang over the USD for the foreseeable future and warrant a dollar discount.
Similar to the USD, the euro traded broadly flat over the past month with price action choppy but the currency ultimately remained range bound. While we remain constructive on the euro in 2019, we expect the euro to remain pressured in the near term. Macro-economic divergence with the US should continue with US economic measures remaining strong and European economic data continuing to be soft.
Near term, Italian debt concerns appear to have been resolved, with indications showing Rome and Brussels reaching a deal. While this deal would remove the risk of excess debt sanctions, long term issues still remain. Revised growth assumptions are still optimistic, meaning we could find ourselves back to square one should projections fail to materialize. As a reminder, Italy's economy is 10 times larger than Greece's, making the potential fallout even more severe.
On the trade front, issues with the US remain unresolved with automotive tariffs in focus as car exports make up 30% of the trade surplus the EU has with the US. Moreover, the US-China trade conflict also matters as the EU is an export focused economy, leaving it vulnerable to direct and indirect trade war impacts. Lastly, there is the risk of a disorderly Brexit.
Ultimately, we expect all these issues to resolve themselves positively and the euro to strengthen as the US economy normalizes and EZ data improves as the headwinds it faced in 2018 fades. This base case should allow the ECB to maintain its well-crafted normalization schedule despite a slowdown in economic activity. We do think that the ECB will be careful not to set expectations for a full blown hiking cycle.
Finally we would like to point out that European parliament elections are scheduled for May 2019. Populist are projected to gain seats but this might not have much impact on the euro as they are a disparate group of left and right wing groups without a common agenda.
As noted in prior commentaries, we expected the GBP to be primarily moved by Brexit headlines and that was certainly the case this past month. Two months ago the GBP moved higher on the back of positive Brexit headlines however we noted that it was difficult to feel confident in the move as a Withdrawal Agreement was just the first step in a long and contentious process and this is exactly what played out.
When PM May delayed the meaningful vote, the GBP weakened to levels not seen since early 2017. The GBP then took another leg lower when a vote of no confidence was called on PM May. Ultimately PM May survived the vote of no confidence but with 117 of her own MPs voting against her, parliamentary math suggest that PM May will not get the deal through on her first attempt, especially given than the EU has refused to reopen negotiations. Parliament is expected to vote on the withdrawal text during the week of January 14.
As a reminder, from an economic point of view, the deal is a positive as it has a provision to extend the transition period to reduce the likelihood of a no-deal outcome. Additionally it has a backstop for the entire UK, not just Northern Ireland, and allows the UK access to other preferential trade deals the EU has with third countries. However, these same conditions have angered pro-Brexit politicians who fear a Brexit in name only scenario. Additionally, PM May's strategy of this deal or no deal raises the stakes as it polarizes possible outcomes.
Our base case continues to be for a negotiated exit, however given the level of opposition, it is possible that there could be an extension to Article 50, pushing out when the UK leaves the EU. Ultimately we believe a desire to avoid no-deal chaos will be enough for Parliament to approve the text but expect elevated headline/volatility risk along the way.
It is important to remember a negotiated Brexit would not completely eliminate real damage to the UK economy or even clarify how severe these consequences if the follow on political declaration on future trade relations is vague. Given this, a negotiated Brexit is positive as it removes the chaos of a no-deal Brexit, and warrants a partial removal of the Brexit risk premium.
Over the past month, the JPY has been the top performer in the G10 space as US 10-year yields have dropped to their lowest level since the middle of 2018.
Looking into 2019, the trend for JPY strength is expected to continue. In 2018, Japanese corporates and investors had historically high levels of foreign investments, which helped push the currency weaker. Weaker global PMI point to slower growth, implying a drop in outward investments. Moreover, the JPY remains a safe haven and it is reasonable to expect elevated levels of volatility in 2019. Trade conflicts remain alive and well, leading not only to safe haven flows but also a drop in Japanese FDI. Beyond the US-China conflict, US-Japan talks are also ongoing. It is likely that the yen's historically weak level will be a point of contention. The JPY's real effective exchange rate—as calculated by the BoJ--is ~25% below its long run (since 1980) average.
Lastly, the BoJ is set to tighten monetary policy as concerns over the long run impact of low interest rates and the narrow window to normalize as a tax hike is imminent. It is noteworthy that while the BoJ has lowered its inflation forecasts, it has also reduced its purchases of long term JGBs, allowing Japanese 10 year yields to rise to the upper end of the BoJ's limit. If the external economy continues to improve as expected, a hawkish shift is very possible especially in light of concerns over the side effects of low/negative interest rates. If this were to happen, the BoJ's first step is likely to eliminate its negative interest rate policy and emphasize that this move is not the beginning of a hiking cycle. This potential for a hawkish shift coupled with a pause for the Fed path points to a stronger yen.
Over the past quarter, the USDCAD broke out to the upside as crude prices fell nearly 45% from its October high. Over this time-frame, the CAD weakened ~6%, making it the second worst performer in the G10 only behind the Norwegian Krone, which is another currency exposed to oil.
Near term, we expect the CAD to remain under pressure as the market works its way through lower oil prices. However lower oil prices are more of a supply issue. Additionally, the BoC struck a dovish tone indicating that there could be room for non-inflationary growth which has pushed back market pricing for its next rate hike. However as we head into 2019, we expect higher oil prices as supply cuts take hold and the Canadian economy picks up momentum.
In past commentaries, we cited NAFTA negotiations as a key driver for the CAD. While an agreement has been struck among the three countries, there remains some ratification risks but ultimately we expect ratification. Striking an agreement on USMCA is supportive for the CAD in the following ways.
The first way is by reducing uncertainty which should help investments and clear the path for further BoC to keep pace with the Fed. The BoC has essentially confirmed that reduced trade policy uncertainty will allow it to continue the rate normalization process with more confidence. Notably, the Fed is closer to the end of its normalization cycle than the BoC, which could enable a modest tightening of interest rate spreads. Additionally Canadian capex should also be bolstered by the recent announcement of increased tax write-offs of investments as a competitive response to the US tax cuts as well as increased net capital inflows as uncertainty fades.
USMCA also effectively protects the Canadian auto sector from additional tariffs as it will be covered by a generous quota system well above that it currently produces. Finally a watered down sunset clause extends the horizon of USMCA's review cycle. Taken together, all these factors bode well for a stronger CAD in the coming year. However it should be noted that the deal does not resolve the dispute of steel and aluminum with those tariffs staying in place.
The AUD spent 2018 in a downward trend and finished the year as one of the worst performers in the G10. This under performance was driven by divergence between the RBA and Fed, as well as slowing Chinese growth and trade concerns as the Australian economy is export heavy with close ties to the Chinese economy. It should be noted that the markets used short AUD positions as a hedge for trade war fears.
Looking at 2019, many of the themes remain in place. The RBA is expected to be on hold for the foreseeable future while the Fed is signaling for two more hikes. Chinese growth is expected to continue to slow and lower commodity prices are expected to continue. Additionally, the trade conflict between the US and China remains unresolved. While we ultimately expect a negotiated deal, the path to that deal is expected to be noisy with no immediate breakthrough is expected. As long as this remains the case, expect the AUD to trade with a risk premium that will keep it pressured.
The argument for a less bearish AUD revolves around the following factors. The first is the USD. While the USD has outperformed since April, tailwinds to the US economy should fade. Moreover, recent domestic data and RBA commentary has been more bullish, supporting the RBA's glass half full narrative. Any signs of trade tensions cooling and strong stimulus in China taking hold and provide support for Chinese growth and stability in the broader EM space would be bullish for the AUD.
After a period of sharp depreciating pressure on the CNY starting in April, the currency has stabilized over the past couple of months.
While there have been many headlines surrounding China manipulating its currency weaker, Chinese authorities have actually worked to strengthen/stabilize the currency. Case in point, the reintroduction of the counter cyclical adjustment (CCA) factor may be the most significant sentiment stabilization step. The CCA factor is designed to offset the influence of higher (CNY weaker) spot closes on the next day's fix. This factor had been in use before being deemphasized in January of this year.
Near term, the trade conflict with the US, which has been complicated by slowdown in domestic growth, should remain the dominant factor. Initially China's response came via monetary policy tools (RRR cut). More recently it appears that the Chinese government has leaned more on fiscal tools. Whether it be monetary or fiscal, the main point is that Chinese authorities have multiple levers to pull and will be using them.
Increases in local government bond issuance implies fiscal stimulus/infrastructure spending in the upcoming months. There has also been efforts to supplement consumption through tax cuts and initiative to drive health care, tourism, and education. All of these measures will likely provide a boost to EM sentiment as a whole. Ultimately growth rates need to actually improve before we reach a sustained period of CNY stability. Until then, risk to the overall macro outlook bias us towards further weakness until the stimulus measures take hold. Of course the wildcard to all of this is how trade talks evolve. A “ceasefire" has been agreed upon and the US and China are scheduled for additional talks in January. However the issues remain difficult and complex, implying a noisy negotiation before ultimately reaching a deal.
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